Bitcoin Value Continues to Puzzle Economists

January 1, 2014

2013 will be a year remembered for many important reasons, with perhaps the most interesting being the rise of the digital currency, the bitcoin.

Bitcoins have been in existence for 4 years now, and over those four years the value of a bitcoin has fluctuated drastically. These intense changes in value make many people wonder what gives a bitcoin value and if they’re worth the investment. Several economists shed some light on the issue.

Nobel Prize winning economist and author of several bestselling books Paul Krugman warns consumers and businesses about the dangers of bitcoins, saying that he is “deeply unconvinced” that the whole bitcoin phenomenon will really work:

“So far almost all of the Bitcoin discussion has been positive economics — can this actually work? And I have to say that I’m still deeply unconvinced. To be successful, money must be both a medium of exchange and a reasonably stable store of value. And it remains completely unclear why BitCoin should be a stable store of value.”

In order to explain why the value of bitcoins are disputed, Krugman points us toward Brad DeLong, who ponders the question himself. DeLong points out that the intrinsic value of gold being used to make pretty things gives it its market value, while the value of the dollar comes from its ability to pay taxes and create transactions here in the US.

Considering bitcoins are a form of digital currency with no intrinsic value, then what gives them a stable, market value?

The answer to that question comes from Business Insider’s Joe Weisenthal, who sees bitcoins as a hybrid of 3 factors: currency, equity, and social network.

Bitcoins are obviously a form of currency due to their ability to complete transactions. While bitcoins were used almost entirely to complete online transactions at their inception, the acceptance of bitcoins as a form of currency in the physical marketplace has drastically increased over the past 4 years. Currently, there are 2,252 locations across the world that accept bitcoins as a form of currency, adding legitimacy to the argument that bitcoins are indeed a form of currency.

Bitcoins are also a form of equity in the fact that the more people who invest in bitcoins and use them as a form of currency, the more the bitcoins are worth. Thus, bitcoins act much like individual stock shares – the more people who invest in a company’s particular stock, the higher stock prices climb due to the increased perception of said company’s value.

However, bitcoins only act as equity as far as its social network exists and continues to grow. This is perhaps the biggest concern to consumers when pondering whether or not to make an investment in bitcoins.

As previously stated, bitcoins have no intrinsic value; they are simply 0’s and 1’s transmitted through the internet. The value of a bitcoin is derived from its use; i.e. bitcoins gain more value as more people use them, much like how Facebook gains value as more people use its service.

But that is where the problem lies. Recent research has shown that Facebook users are declining, especially in the younger generation. If Facebook users continue to decline, it could wind-up facing the same fate that befell MySpace.

Or, as Joe Weisenthal put it, “Without the network effects, the technology is nothing. It’s just a theoretical amusement.”

So, in the end, the value of a bitcoin will be ever-fluctuating as its numbers of users and businesses which accept payment continue to fluctuate. While one bitcoin is worth $750.99 today, its value could easily increase or decrease ten-fold overnight.

If you’re still questioning whether or not you should invest in bitcoins, ask yourself this: Do you have surplus cash that you don’t know what to do with? If that answer is yes, invest in some bitcoins, ride the bubble, and hope the gamble pays off (and if it does, send some of those excess bitcoins this way).